.Net Programming - Financial independence

Invest With Exchange Traded Funds on Low Saving Rate

One of the most common case I have when I talk to people interested in investing is the fact that they have very limited funds available, either by having a low income or a low saving rate. In fact, they easily buy in the index investing strategy and would like to own Vanguard Index ETFs as well but buying them is more efficient when the investing in bigger chunks. Why? Because of the brokerage fees. That prevents automatic bi-monthly deposits and might require people investing in small amounts a bit of gymnastic to stay focus and see interesting returns.

Brokerage Fees to Invested Amount Ratio

Let’s say that it costs 10 $ to buy any stock with my online broker. That counts for ETFs also because Exchange Traded Funds are bought like any other stocks on the stock market.

If I buy 100 $ of one ETF, that would be 10 shares if the shares are 10 $ each. 100 $ for the shares and 10 $ for the transaction brokerage fee. Therefore, my fee to invested money ratio is 1/10 or 1 $ for every dollar invested which is not very good at all. It costs me 110 $ for 100 $ of shares.

On the other hand, if I invest 10 000 $, my fee to invested money ratio is now much better at 10 $/10 000 $ = 0,001 $ that is 1 cent for every dollar invested. It now costs me 10 010 $ for 10 000 $ of shares, much better.

You can see from both examples that the larger my investment amount is, the best ratio I get and the less fees I am paying per dollar invested. That’s why it’s hard for people with small amounts of money saved to get a good price for what they put in.

How It Translates Visually

Investment Fee Ratio

As shown above, we can compare a 100 $ investment for which the fee is equivalent to 10 % of the value versus a 50 000 $ investment which the fee constitutes 0.02 % of the value. That’s a huge difference. Let’s see how much it would cost to invest 100 000 $ with transfers of 100 $ vs transfers of 10 000 $.

You will need to make 1000 deposits to reach 100 000 $ with deposits of 100 $.

1000 X 10 $ commission = 10 000 $ in brokerage fees.

With deposits of 10 000, it’s going to be only 10.

10 X 10 = 100 $ in fees.

Keep in mind that most portfolios are divided in more than one part. That would mean 10 $ times the number of parts, each time to rebalance.

What’s A Good Ratio for investing in ETFs? Personally, I’d say invest in chunks of anything above 5 000 $ but preferably above 10 000 $ depending on the amount of parts in your portfolio. Anyways that’s what I use and most of my portfolios have 4 to 5 parts each. That means 40 to 50 $ per rebalance.

It’s Very Hard to Stay Focused

According to the last calculations, you can figure out that it’s a lot better to wait until you have a big chunk of cash to invest or reinvest. This is not always easy when you don’t have a big saving rate per paycheck. It can be discouraging to wait until 5 000 $ if you can only spare 250 $ per paycheck. 20 paychecks will be necessary, that’s almost a year if you’re paid per two weeks! That’s if you are not tempted to take some away from that juicy 3 000 $ laying around in your savings account.

This is in part why I found people fail at staying focused. It’s simply not going fast enough because the lump sums required are too big. The other part comes from how low the return is on small amounts. For example, 10 % is a very good return but 10 % on 20 000 $ is only 2 000 $ while 10 % on 1 000 000 $ is 100 000 $. I don’t have to add anything to say that the second gives you a lot more buying power. Therefore, it takes a long time to see the real rewards and by the time people realize it, they’re already retired.

It’s just how our minds work, we are not good at seeing the effect of compounding and we want immediate compensation, like getting rich quick.

How Reduce External Fees and Still Invest

You can’t get around the brokerage fee or management expense ratio (MER). But you can find places where those fees are still low to be able to contribute regularly and be invested. That might translate in you having to pay more in some other way. Still, it will keep you focused with the feeling of making your money work for you.

Use Mutual Funds (Temporarily)

Good, no-load and no buying fee mutual funds can be a good option if you really want to just start somewhere. Let’s say for the first 20 000 $. I would stay around 1 % management expense ratio or lower if possible. The big advantage with mutual funds that don’t charge when you put money in is that you can contribute each month without the brokerage fee. This is rewarding and can be beneficial to protect your investments against your hunger for buying stuff you probably don’t need. I agree, mutual funds can be (much) more expensive but they can still get you exposed to the market and keep you motivated to save more. Once you get into the big game though, let’s say 50 000 $ – 100 000 $ + invested, I would change to full ETFs to save a lot in management fees in the long run.

Another alternative would be to use a mutual fund as an intermediate between your ETFs and your savings account. That way you could transfer per paycheck savings into the mutual fund which will cost no brokerage fee and then once the amount is big enough, transfer into ETFs. Just like the image below.

Use mutual funds to invest in ETFs

Just make sure to assess the risk of both the mutual fund and the ETFs portfolio to match your risk tolerance. One last thing, this method does have a down side if you’re using it outside a registered account like a TFSA or a RRSP. It will trigger capital gains if you sell and then reinvest and influence your tax bill.

Remember that you need an horizon of at least five years depending on the risk you’re willing to take but you should do a lot of research on the products you’re buying just like buying a car. Research that most people don’t do sadly. Knowledge is power.

Full Service Investment Platforms

Full service investment platforms like Robinhood (United States and United Kingdom only), betterment (United States) or Wealthsimple (Canada) can make the task very easy for a fee most of the time lower than Mutual Funds but higher than ETFs alone. They will manage your assets according to a certain plan you can select. They can also rebalance your portfolio and most of the time have very low entry deposit, meaning you don’t have to put that much money down to get started.

These platforms are good if you don’t give much of a single crap about all that rebalancing and asset allocation magic and just want returns on your diversified investments.

Just a quick warning: you should still watch out to make sure you don’t fall into lousy investments like options or cryptocurrencies as these investments can be very risky. You can gain big as much as you can lose big and it honestly gets closer to gambling than investing in my opinion. Robinhood offers these types of “investments”.

Have a Less Complex Portfolio

I am talking about the number of parts you have in your portfolio. Like VCN, XAW and VAB would be a three parts portfolio. Instead, you could use a single asset portfolio with one part or a simplified version of your target portfolio with only two parts. Rebalancing would be less costly (10 $ per part for this example) in that case and sometimes rebalancing only once a year could be enough for you.

Vanguard Canada offers a few ETFs that are balanced in a certain way. They are a single asset and could be relied on until you have either a greater saving rate or a larger amount in your portfolio or simply would like more control over what is invested where and how. See the Vanguard Website for more information. They are a bit more expensive but not as much as Full Service Investment Platforms.

Rebalance Less Often

As I pointed above, rebalancing once a year can be enough for most of us. Personally I only rebalance when I put money in. The downside of rebalancing less often is that your portfolio might become out of balance and a little more vulnerable to big drops in the stocks or the fixed income (bonds) market. It’s a trade-off you will have to evaluate for your own situation.

Lower Your Expenses

Lower your expenses to save more money, easier said than done I admit but if I can find ingenious ways to save money, anyone can! You need to save as much as possible if you want to get the lump sum you need to invest in ETFs. In fact, the alternatives presented above are good, but you often pay a premium for them. If that suits you it’s good, but if you want to reduce the constant management expense ratio (MER) to a minimum, index ETFs are the way to go. Also, saving money is much more efficient than getting a pay raise.

Increase Your Salary

Well this one is surely a nice to have, but it’s a double edged sword as you will also pay more taxes, which is not the case if you lower your expenses. Also, you might be tempted to increase your lifestyle at the same time (lifestyle creep).

An increase in salary can also be accomplished by switching jobs or switching careers completely. In addition, you could have a side-hustle, but I know I am not the one to speak because this blog is actually my side-hustle but I would not recommend it unless you really like your side-job. In part because it will drain your energy at a record breaking speed and might not be so worth it in the beginning.

Use Another Investing Platform With Lower Brokerage Fees

Big banks are rarely the ones with the lowest fees. Services like Wealthsimple Trade have lower brokerage fees (or no fees at all!) but might be less stable or reliable as seen with the Robinhood service down time lately on March 2nd 2020. That said, if you’re in for the long term, it might not affect you that much. It’s worth taking a look because that would mean you could invest in ETFs even with small amounts. Then you would need to rebalance yourself but that’s a minor concern given all the money you would save on management expense ratio compared to full service platforms. Best of both worlds!

To Keep in Mind About Management Expense Ratio

Keep in mind that, honestly, brokerage fees are just a fraction of what it can cost to have a 1 % or more management expense ratio (MER). In the example below, I compare two arbitrarily selected funds. One at 1.04 % and the other one at 0.16 % MER.

Management expense ratio comparison.

Notice that over 30 years, given the same performance, the fund with 1.04 % MER costs you around 57 000 $ more in management fees. It would take a whole lot of transactions at 10 $ to top that! The less you earn, the more every single dollar you invest is valuable. This applies to both mutual funds and full service investment platforms as they also charge MER.

Index ETFs Are Great Even On Low Saving Rate

Index ETFs are great even if your saving rate is not extreme. They have a very low management expense ratio, are very diversified and are easy to trade on the market. The downside is that their nature inquires brokerage fees for rebalancing multi-parts portfolios. These can be a bit costly if you don’t have that much to put in your annual rebalance or if you rebalance multiple times a year. On the bright side, it’s very often a lot less expensive than a higher MER in the long run. So, even with less to invest, you can benefit from indexing.

If you have a lower saving rate, you might want to look at alternatives if you aim to be as effective as possible and have difficulty staying focus. Also, remember that your saving rate is your greatest weapon to use exclusively ETFs and reduce external fees. Work on increasing it and you will be able to gather a big enough amount of money to be effective at your rebalance date. In the meantime, you might want to consider using mutual funds, full service investment platforms or manage your finances differently to get ahead. You have to see for yourself depending on your situation.

Finally, on a more financial independence note, figuring out a balance between saving a lot and living a plentiful life is an art to be mastered with time. It requires being creative and going in the opposite direction of the mass, but is possible to accomplish by all of us.

Good investing everyone!

Disclaimer: make sure to always do your research before investing, I am not in charge of your money, you are.

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